by Michael Pettis, China Financial Markets
Five or six years ago, a few skeptics first started pointing out that the credit dynamics underlying Chinese growth was creating an unsustainable increase in debt. This, they warned, would ultimately undermine the banking system and cause growth to collapse if it were not addressed in time.
There were three standard rejoinders to the warnings. First, analysts argued that investment was not being misallocated, and because credit growth poured mostly into investment, it did not therefore follow, as the skeptics argued, that debt was rising faster than debt servicing capacity. Although I think few analysts still support this argument, there remain some analysts who do not think China has an overinvestment problem. For example my Carnegie colleague Yukon Huang, who has argued, for example in one of the FT blogs that China is actually underinvested:
The perception that China has invested too much is also misleading. Actually, China’s capital stock relative to GDP is lower than other comparable east Asian countries. Moreover, much of the surge in investment over the past decade is due to housing construction, where the country is still making up for the shortfalls from the Mao era.
Because I have addressed this issue many times before in my newsletters, especially the common and distressingly ahistorical fallacy that one can determine whether a very poor country like China is over- or under-invested by comparing its capital stock per capita to more advanced countries with much higher levels of social capital and the consequent ability to absorb investment efficiently, I will not do so again. Needless to say, I think that the evidence of investment misallocation has continued to rise, and in the past two years the number of analysts that are not worried about a systematic tendency for debt to rise faster than debt-servicing capacity has dropped significantly. I have no doubt that their refusal to accept the consensus on the subject is useful in that it helps sharpen the debate, but this is a losing battle and, like the capital stock argument, distressingly ahistorical.
The second rejoinder, which has also largely faded away as an argument over the past few years, is that debt in China doesn’t matter. Sometimes, these analysts argue, it doesn’t matter because it is funded domestically. Sometimes it doesn’t matter because the banks are implicitly guaranteed by the central government. Sometimes it doesn’t matter because China was able to resolve its last debt crisis, 10-15 years ago, in an environment of rapid growth and at no cost, and so of course it can do so again.
Again I have addressed all of these arguments as to why debt doesn’t matter in China many times before and it is pretty easy to show that all of these claims are fairly nonsensical, and this is especially obvious from the very wide range of historical precedents. Debt always matters. Either it must be repaid out of the proceeds of the investment that was funded by the debt, or – if the debt funded consumption or was misallocated into insufficiently productive investments – it must be repaid by transfers from some other sector of the economy, and these transfers reduce growth by reducing real demand.
The third rejoinder should have been, in principle, the easiest to refute, and for a while it looked like it had been refuted to everyone’s satisfaction, but in the past year I have seen a revival. China doesn’t have to worry about rising bad debts in its banking sector, according to this argument, because the PBoC’s extensive reserves will make it easy to recapitalize the banks.
Ray Chan, of the South China Morning Post, for example, had an interesting article last Saturday that made this point. He starts off the article by warning that the rapid growth of credit in China has uneasy parallels with rapid credit growth in the US before the 2007 crisis:
Parallels between the United States and China have started to look more ominous after several years of rampant credit growth and the emergence of an increasingly uncontrollable and unsustainable shadow banking system. China’s massive foreign reserves could, however, be the last tool in the bag for its bank-centric financial system if no timely regulations are implemented.
With the memory of the collapse of Lehman Brothers in 2008 still fresh, investors are fretting over the growth of thinly regulated shadow banking activity. Trusts, entrusted loans and bank acceptance bills shot up sharply to a record 294 billion yuan (HK$370 billion) last month. According to Moody’s Analytics, China’s core shadow banking products, which are often opaque and subject to little or no regulation, almost doubled to 20.5 trillion yuan last year from 11.7 trillion yuan in 2010. The US firm excludes entrusted loans and trust loans as they own underlying assets.
Debt and reserves
The article does a good job of listing many of the problems that have emerged in the past few years, but then quotes a number of analysts who argue that China’s problems is very different from that of the US and it is unlikely to suffer the same kind of crisis. The article continues:
China’s credit situation is somewhat different, though, as it has a high saving rate and massive foreign reserves. Mervyn Davies, a former head of Standard Chartered and British government minister, said:
“China is very rich in reserves … At the end of the day, the [Chinese] banks do need recapitalising, which is not a huge challenge to them because the government can recapitalise the banks.”
I agree that China is in a very different position than the US, but this isn’t necessarily a good thing. The main relevant difference is that because all the banks are perceived to be guaranteed by the central government, and Chinese households have a limited number of ways to save outside the banking system, it is unlikely that China will experience a system-wide bank run as long as the credibility of the guarantee survives, and runs on individual banks can be resolved by regulatory fiat (banks that receive deposits will be forced to lend to banks that lose deposits). We are not likely to see a Lehman-style crisis.
We are also not likely to see, however, the advantages of a Lehman-style crisis, and these are a relatively quick adjustment in the process of investment misallocation. I have always said that the resolution of the Chinese banking problems is far more likely to resemble that of Japan than the US, and instead of three of four chaotic years as the system adjusts quickly, and at times violently, we are more likely to see a decade or more of a slow grinding-away of the debt excesses. The net economic cost is likely to be higher in a Japanese-style rebalancing, but American-style rebalancing is risky except in countries with very flexible institutions – financial as well as political.
But I do disagree very strongly with Mervyn Davies’ claim that because the PBoC is “very rich in reserves” it will not be much of a challenge to recapitalize the banks. China’s reserves only matter to its credit position if China faced a problem of external debt.
It doesn’t, and so the amount of reserves are almost wholly irrelevant, Because this argument seems to be reviving, it makes sense, I think, to repeat why central bank reserves cannot in any way help China resolve the crisis. I will leave aside the problems of whether the reserves are transferred in the form of foreign currency, in which case it does little to satisfy domestic RMB-denominated funding needs, or in RMB, in which case the PBoC must stop buying dollars in order to hold down the value of the RMB and in fact must sell dollars, which would cause the value of the RMB to soar, thereby wiping out the export sector in China.
A much more important objection is that the idea that reserves can be used to clean up the banks (or anything else, for that matter) is based on a misunderstanding about how the reserves were accumulated in the first place. There seems to be a still-widespread perception that PBoC reserves represent a hoard of unencumbered savings that the PBoC has somehow managed to collect.
But of course they are not. The PBoC has been forced to buy the reserves as a function of its intervention to manage the value of the RMB. And as they were forced to buy the reserves, the PBoC had to fund the purchases, which it did by borrowing RMB in the domestic market.
This means that the foreign currency reserves are simply the asset side of a balance sheet against which there are liabilities. What is more, remember that the RMB has appreciated by more than 30% since July, 2005, so that the value of the assets has dropped in RMB terms even as the value of the liabilities has remained the same, and this has been exacerbated by the lower interest rate the PBoC currently earns on its assets compared to the interest rate it pays on much of its liabilities.
In fact there have been rumors for years that the PBoC would be insolvent if its assets and liabilities were correctly marked, but whether or not this is true, any transfer of foreign currency reserves to bail out Chinese banks would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities. The net liabilities of the PBoC, in other words, would rise by exactly the amount of the transfer. Because the liabilities of the PBoC are presumed to be the liabilities of the central government, the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks.
This is the point. Any government that is able to borrow money can borrow money to recapitalize its banks, whether or not it has large amounts of foreign currency reserves. The amount of central bank reserves that China or any other country has is wholly irrelevant, except perhaps to the extent that without those reserves the central government would lack the credibility to borrow domestically, which hardly seems to be a concern in China’s case.
Bailing out the banks, it turns out, is conceptually no different than transferring debt from the banks to the central government. China can handle bad debts in the banking system, in other words, by transferring the net obligations from the banks to the central government, and the large hoard of reserves held by the PBoC does not make it any easier for China can resolve any future debt problems. In fact if anything it should remind us that when we are trying to calculate the total amount of debt the central government owes, the total should include any net liabilities of the PBoC, and that these net liabilities will increase by 1% of GDP every time the RMB strengthens against the dollar by 2%.
Does hidden debt matter?
Before finishing on this topic, I want to address another related fallacy that pops up a surprisingly large number of times when I discuss the net liabilities of the central bank. I am often told that because these liabilities are hidden in the central bank books, and so no one really knows how much debt the PBoC adds to the central government’s debt burden, they really shouldn’t matter in our calculations. The central bank will presumably never default because its obligations are guaranteed by the central government, and its net liability position is hidden, so why bother even consider the PBoC’s balance sheet when assessing China’s debt position?
Even those who do not understand why this reasoning is incorrect should know that it must obviously be incorrect. If it weren’t, any country could solve all of its debt problems merely by borrowing in a non-transparent way through the central bank. As the Greeks and the Italians most recently showed us, non-transparent borrowing may cause us to recognize problems later than we otherwise would have, but it cannot solve the problem.
The reason is because in any case debt must either be serviced or the borrower must default. If the assets which were funded by the debt do not create enough wealth with which to service the debt, and if the borrower does not default, then by definition there must have been a transfer from some other entity to cover the difference between the debt servicing cost and the returns on the asset.
Typically this other entity, in China and elsewhere, has been the household sector, and in the case of China the transfer occurred primarily in the hidden form of severely repressed interest rates. Whether the transfer is from the household sector, however, or from other sector, this is where the problem of debt lies for China.
If the central bank (or the commercial banks or any other borrower whose obligations are covered by the central government) is unable to service its debt – and remember that the “economic” debt servicing cost is not the coupon, which is repressed by policymakers, but consists of whatever the “natural” interest rate would have been – the difference will be paid for by someone else, and the economy will suffer slower growth because of the reduction in demand caused by the transfer payment.
So who is likely to cover the cost of NPLs in Chinese banks? This isn’t an easy question to answer. If the household sector continues to pay, either in the hidden form of repressed interest rates, or in the more explicit form of taxes, the existence of bad debt in the Chinese banking system must act to repress future household consumption growth. The transfers from the household sector to pay what may turn out to be a huge NPL bill will significantly lower the household income share of GDP, making it very unlikely that the household consumption share of GDP will rise.
If however the state sector covers the difference (perhaps by privatizing state assets and using the proceeds to pay down debt), we are left with the very difficult political problems, which China currently faces, of assigning the costs to different sectors or groups that control the state sector in China. The potentially very large cost of cleaning up NPLs must be assigned to groups that are likely to be both powerful and reluctant to pay the cost.
Debt always matters because it must always be paid for by someone. Even if the borrower defaults, of course, the debt is simply “paid” by the lender. This is why the fact that debt in China seems to be growing much faster than debt-servicing capacity implies slower growth in the future. If the debt cannot be fully serviced by the increase in productivity created by the investment that the debt funded, unless it is funded by liquidating state sector assets it must cause a reduction in demand elsewhere, most probably in household consumption. This reduction in demand implies slower growth in the future and, of course, a more difficult rebalancing process.